Royal Caribbean Stock Could Sink 50%

By

Ryan Brettell of Valtura Capital Partners

Nov. 2, 2017 7:53 a.m. ET

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Kiyoshi Ota/Bloomberg

This article first appeared on SumZero, the world’s largest research community of buyside investment professionals. In some cases Barron’s edits the research for brevity; professional investors can access the full version of this thesis and tens of thousands of others at SumZero.com.

Disclaimer: The author of this idea and the author’s fund had a position in this security at the time of posting and may trade in and out of this position without informing the SumZero community.

Royal Caribbean Cruises is the world’s second-largest cruise line (behind Carnival), operating more than 40 ships with over 120,000 berths annually and accounting for approximately 25% of the global cruise market.

Royal Caribbean Cruises (RCL)

TARGET PRICE:

$75

INITIAL PRICE:

$127.48, Oct. 18

CLOSING PRICE:

$120.86

Royal Caribbean (ticker: RCL) travels to 535 destinations under three primary brands, Royal Caribbean International, Celebrity Cruises and Azamara Club Cruises. We had previously looked at the cruise lines as a short theme in early 2016, as signs began to form of looming record-setting supply growth in coming years. Due to the high operating leverage and cyclicality in the industry, it seemed this could result in significant stock price depreciation in the event of any type of macroeconomic, cruise-related, or even broader travel-related weakness. However, there was no hard catalyst, and with short interest already approaching 10%, it was tough to short the cruise-line stocks at time.

Sure enough, since then, the cruise-pricing cycle has continued to lengthen to further record levels, which has caused investors and sell-side analysts to continue to extrapolate current fundamentals as if they are due to secular forces instead of cyclical ones (20 buys and 5 holds). Royal Caribbean stock is up over 85% over the last 12 months, has short interest of 2%, and trades at record highs on a book value basis (we believe this is a more appropriate valuation metric for a company that is highly cyclical, has generated significantly negative free cash flow through cycles, and doesn’t earn its cost of capital).

We believe current valuations ignore the record multiyear supply growth the industry is still facing and fail to account for the material operating and financial leverage in the industry. Increasing geopolitical tension (North Korea, China, Japan) directly impacts demand for the cruise-line market, and recent hurricanes in the Caribbean, which accounts for 39% of the market, could materially impact demand in the region. In addition to these broader industry catalysts, we believe Royal Caribbean in particular has significantly overearned in the prior year in order to reach management’s ambitious “Double Double” goals.

Because of this, we believe it will be difficult for the company to significantly grow earnings in the coming quarters. As earnings and industry fundamentals normalize, we believe Royal Caribbean stock can ultimately be down more than 50% from current levels.

In prior industry downturns, Royal Caribbean has traded well under book value, compared to its current nearly 3 times valuation, so there is plenty of downside should sentiment turn on the stocks. However risks to the upside exist. Bulls will argue that book value doesn’t matter and the company should trade on a price/earnings multiple basis. We would argue the stock already trades at premium multiples to its historical range (17 times 2017 and 15 times 2018), but bulls will argue where it trades relative to the market.

Additionally, a short-term positive catalyst is the Investor Event in early November, in which the company is expected to unveil its new long-term goals. Given their last set of long-term goals, we imagine they will be ambitious, though management’s tone has been mixed on the issue. Additionally, emerging potential opportunities in China and Cuba, increasing efficiency in new ships (fuel and operating efficiency), and the shift in consumers shifting from goods to experiences are all upside variables. However, we believe this is more than priced in, and the stock could easily be down 50%, should any of the downside catalysts occur.

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